Complacency Rules as Investors Ignore Risks From China to Trump

Complacency is a word that worried people use when they think other people should be more worried.

And sometimes, the worriers are right. Or, at least -- they sound right if anyone will listen.

Suzanne Hutchins, a portfolio manager of the $1.5 billion Dreyfus Global Real Return Fund (DRRIX) at Bank of New York Mellon Corp. (BK) , is one such worrier.

Spend half an hour on the phone with her and she'll rattle off an earful of worries: elevated stock-market valuations, China's economic slowdown, the currency crisis in Turkey, President Donald Trump's trade wars, the Federal Reserve interest-rate increases and balance-sheet shrinkage, recriminations over Britain's exit from the European Union, nascent impeachment talk in the U.S., North Korea's on-again, off-again nuclear ambitions.

Her broad complaint, though, is that investors don't seem to be troubled by it all.

"There's a lot to worry about right now," Hutchins says in a phone interview. "The market is complacent."

Based on the recent performance of the Standard & Poor's 500 Index of U.S. stocks, she's right that investors, as a whole, look unbothered. The index is up 7.6% this year and set a record in August for the longest bull market in history - at more than 113 months. The S&P 500 is currently trading at about 20 times the past 12 months' earnings, well above the 10-year average of 16.18.

Such a multiple might be indicative of how well the U.S. economy is performing thanks to the stimulus from Trump's $1.5 trillion of tax cuts in December. Or it might just mean that, for stock traders, the biggest gains are over.

"The U.S. economy looks in pretty good shape but we think the market has priced it in," Hutchins said. "We've been taking risk off the table as markets have trended higher."

It's a classic trope of fund managers to claim that markets have fully digested some factors, while completely missing others -- book-talking 101, as it were. But maybe she's onto something.

Listen to her views on the economic woes now facing Turkey. She isn't in the camp of economists predicting that the crisis there will initiate a chain of follow-on crises throughout the global economy; the country's currency, the lira, has tumbled 70% this year against the dollar. Rather, she says, Turkey's crisis is a symptom of all the debt that was piled on by borrowers over the past decade as central banks in the U.S., Europe and Japan cut interest rates to zero or even negative levels to revive markets following the financial crisis of 2008.

Worldwide, the total debt of banks, non-financial corporations, governments and households has increased by 40% over the past decade to a record $247 trillion, according to the Institute of International Finance, an association of banks.

"Turkey in itself I don't think is a major issue," she said. "But it's an example of the misallocation of capital. Many countries like Turkey have been feeding on that bonanza and it's now coming home to roost."

Take China, the world's second-largest economy. Chinese authorities have loaded their domestic economy with debt to spark growth. But now, with a total debt load that's climbed to almost three times gross domestic product, from 1.7 times a decade ago, the economy is starting to slow. According to FactSet, economists on average expect the country's economic to slip to 6.6% this year, from 6.9% in 2017. For most of the past three decades, the country has posted annual growth rates north of 7%.

As the Federal Reserve has raised rates in the U.S., and as Trump has imposed and threatened tariffs on more than $500 billion of Chinese imports, the yuan is down 5.4% this year versus the dollar. That's despite China managing its foreign-exchange and interest rates closely. Authorities also keep tight controls on capital leaving the country. But the controls aren't perfect.

"There is a lot of capital trying to get out of the country," Hutchins says. "I'm sure there will be leakage out of the system."

Suzanne Hutchins, portfolio manager of the $1.5 billion Dreyfus Global Real Return Fund, says investors are too complacent about mounting market risks.
Suzanne Hutchins, portfolio manager of the $1.5 billion Dreyfus Global Real Return Fund, says investors are too complacent about mounting market risks.

The Global Real Return Fund aims to beat the London Interbank Offered Rate - a benchmark of dollar-based short-term interest rates - plus 4 percentage points. From inception through June, the fund has returned 7.6% annually, beating its goal by an average 1.4 percentage points. According to Morningstar, it ranks in the top fifth of funds in its category, "U.S. Fund Multialternative."

And as one might imagine given Hutchins's dour outlook, the investments are hedged. The fund has a 49% allocation to stocks but uses futures contracts to reduce that exposure to 39%. Other investments include bonds in Australia and New Zealand, where inflation-adjusted yields are positive, according to a spokeswoman. The currency exposure is hedged back to U.S. dollars. Some 2.6% of the fund is in gold-related assets.

Yet there's still a lot of naysaying of the naysaying. Mark Hackett, chief of investment research at Nationwide, an insurance and asset-management company, says he sees the S&P 500 climbing 5% or more over the rest of this year, fueled in part by companies buying back their own shares at a record pace. The financial-engineering tactic leads to an immediate increase in earnings per share.

At the same time, the U.S. economy is thriving, leading analysts to raise their estimates of companies' future profits. And, he notes, many investors are shifting their investments from stocks into bonds - not exactly a sign of irrational exuberance.

"How do you short this market right now?" Hackett said in a phone interview.

Hutchins, the manager of the Dreyfus fund, says she doesn't think the U.S. stock market will ultimately be immune from the accumulating global risks.

Recently, she's paid the price for her pessimism. Over the past year, the fund has lost 0.2%, even as its benchmark returned a positive 4.4%.

"We have been quite cautious about the level of markets for a few years now," Hutchins said. "And obviously we've been wrong because we've been early."

Better early than never?

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